Asset and liability management: form and function of the committee

Federal Home Loan Bank Board Journal, April, 1984 by William C. Handorf, Michael P. McCarthy

Similarly, thrifts can offer nonprice competition to gain market share. Associations offer new services at prices below cost, advertise extensively, or open new places (branches or automated teller machines) to transact business. Such actions carry possible adverse consequences in the form of higher operating expenses and higher non-earning assets. Asset/liability decisions must be able to anticipate and differentiate the likely interaction of such events.

Spread. Similarly, a thrift can attempt to increase the interest margin by changing its interest spread--the difference between the percentage return on assets and percentage cost of liabilities. Since one institution has very little influence on open market yields, it may first focus on the loan portfolio to enhance the overall asset yield. However, those loan repricing decisions capable of increasing the spread are typically the same ones whill will normally lose business volume. While some thrifts are able to successfully stratify their customer market and offer premium-priced loans through attentive personal service, most associations still respond to the full range of customers. As a result, higher prices lose loan business and what interest margin is gained through pricing may be fully or partially lost through volume. The exact influence again depends on the elasticity of loan demand to interest rates.

Conversely, management can improve the spread by purchasing funds and offering deposits at less than competitive rates. Thrifts can also pay the same nominal rate but compound less frequently. The likely loss of business and volume is obvious in competitive markets. Still, some associations find that customers will smaller balances may not be as sensitive to interest rates, and competitive, let alone premium, rates are not needed to retain savings.

Mix. The third and most likely strategy designed to enhance the margin today is to alter the asset/liability mix. First, thrifts can reduce their liquidity by minimizing cash and due from accounts and investing the proceeds in short-term marketable securities. Such actions increase slightly the liquidity risk of being unable to meet customer demands. The probable negative impact of an association failing to manage liquidity is a critical constraint of the asset/liability committee. Further, such actions might precipitate a loss of correspondent services which will merely increase operating expenses as the lost services are bought elsewhere. Similarly, thrifts can reduce liquidity by more fully purchasing fund short-term, thereby increasing the volatility of the funding base. Since short-term funds often cost less than those of a longer maturity, the action once more illustrates the trade-off of earnings verus liquidity. More aggressive management will take advantage of the shifts in the yield curve and alter the mix of short-term securities and purchased funds to take advantage of interest rate movements.

As another alternative, management can increase lending aggressiveness by increasing the loan ratio, by offering credit to less strong customers, or by entering the construction, commercial, and consumer loan markets. The likely impact of this action is an increase in loan losses and a possible reduction in net income. Similarly, the higher exposure to credit risk carries with it a presumption of added funding by capital--the most expensive and difficult to obtain source of institutional funds.